Externalities and Production Efficiency

Abstract

Environmental improvements should be sought from different polluters (public or private, producer or consumer, rich or poor) at the same cost, regardless of the nature of the polluting activity. Under a plausible structure of monitoring costs, emissions standards play a central role. Eskeland brings together two of government's primary challenges: Environmental protection and taxation to generate revenues.

If negative externalities can be reduced not only by changes in consumption patterns but also by making each activity cleaner (abatement efforts), how shall inducements to various approaches be combined? If negative externalities are caused by agents as different as consumers, producers, and government, how does optimal policy combine inducements to reduce pollution?

Intuitively it seems right to tax emissions neutrally, based on marginal damages - no matter which activity pollutes or whether the polluter is rich or poor, consumer or producer, private or public. Eskeland provides a theoretical basis for such simplicity. Three assumptions are critical to his analysis:

Returns to scale do not influence the traditional problem of revenue generation.

Consumers have equal access to pollution abatement opportunities (but he also relaxes this assumption).

Planners can differentiate policy instruments (emission taxes or abatement standards) by polluting good, and by whether the polluter is a consumer, producer, or government, but they cannot differentiate such instruments (or commodity taxes) by personal characteristics or make them nonlinear in individual emissions.

Among Eskeland's findings and conclusions: Abatement efforts and consumption adjustments at all stages are optimally stimulated by a uniform emission tax levied simply where emissions occur. It simplifies things that optimal abatement is independent of whether the car is used by government, firms, or households - for weddings or for work. It also simplifies implementation that the stimulus to abatement at one stage (say, the factory) is independent of whether it yields emission reductions from the factory or from others (say, from car owners who buy the factory's products).

Finally, ministers of finance and of the environment should coordinate efforts, but they need not engage in each other's business. The minister of environment need not know which commodities are elastic in demand and thus would bear a low commodity tax. The finance minister need not know which commodities or agents pollute or who pays emission taxes.

This paper - a product of Public Economics, Development Research Group - is part of a larger effort in the group to establish principles for public intervention.

JEL Classification: D62, H21, H23, Q28